What is a secured loan and what does it do? Let’s start by understanding what it doesn’t do. It doesn’t penalize you for not having or possessing a poor credit history. It doesn’t entail a high interest rate as this type of debt is less risky for the lender. Finally, it doesn’t restrict your borrowing limits as much as unsecured loans do.
A secured loan is backed by an asset or “collateral” such as real estate (e.g., Mortgage) or a vehicle (e.g., an Auto loan). The lender is legally authorized to seize the collateral if the borrower defaults on payments. The risk, in this case, is tilted toward the borrower. Secured loans may be considered as a last resort by somebody who has a bad credit history but is say, a homeowner. However, secured loans are not just an option for people with bad credit history. A homeowner with a good credit history but wanting to borrow a higher amount—an option which isn’t available with unsecured loans—could also opt for a secured loan against their property.
On the other hand, unsecured loans are just backed by your promise of repayments in fixed installments over a fixed period. In this case, you haven’t pledged anything to obtain the loan. This option is usually available for people who have a decent credit history. Common examples include credit card loans and student loans. Because the risk of default or counterparty risk to the lender is higher in the case of unsecured loans, interest rates tend to be higher.
Usually, the borrowers of secured loans are also simultaneously buying a property and the property in question, e.g., a house, is used as collateral by the lender. This is more commonly known as a “mortgage.” You can get additional loans secured on your home for expenses such as home improvements or debt consolidation. This is usually referred to as a “second mortgage” or “homeowner loans.” Bear in mind, taking out a second mortgage could mean more repayments, and they are second in order of priority to your first mortgage. Naturally, this implies that the amount you can borrow is lower and the interest charged is relatively higher, to account for the risk.
With second mortgages, the amount you can borrow, the duration of the loan and the interest rate offered, are all dependent on your credit history, your income, current credit commitments and the amount of equity you have in the property. The equity you possess in the property is the difference between the value of your home and the amount owed on your mortgage. Equity is instrumental in calculating the loan-to-value (LTV) ratio. This information helps the lender ascertain how much money they could recover from selling your house if you default on your payments. An LTV of 80% would imply that a lender won’t be willing to lend more than 80% of your equity in the house. Typically, the more equity you have in the property, the more you’ll be able to borrow.
Failure to repay can have serious ramifications, including a negative impact on your credit score, or worse, repossession of your property. However, lenders usually make less money from repossessing properties than having their debt paid. So it might be a good idea to let the lender know right away if you fall behind with your payments. Sometimes, they might be able to arrange a new schedule for repayments.
In a nutshell, secured loans usually offer lower interest rates and access to larger amounts of money when compared to unsecured loans. Even if you possess a bad credit report, taking out a secured loan could serve as a counterintuitive measure to improve your credit score. If you keep making payments regularly, you can establish or rebuild your credit history.